A
man fires a rental M9 A1 military flame thrower shooting napalm
during the Knob Creek Machine Gun Shoot near West Point, Kentucky
April 9, 2005. Thousands of machine gun and military hardware
enthusiasts attended the event held each year over weekends in
the spring and fall.Rick
Wilking/Reuters

The article features a former Target logistics manager who has
goosed his net worth up to $12 million by betting that the VIX
will go down. He is in the process of raising $100 million for a
VIX-smashing hedge fund.

I probably had about 20 readers send me this article. They are
very scornful of this guy.

Is it jealousy? Not really. People who understand the dynamics of
these products know that it is the definition of picking up
nickels in front of a steamroller.

About those nickels...

Risk/Reward

There are two types of trades:

You risk a little to make a lot.

You risk a lot to make a little.

In gambling terms, the former is “taking odds,” and the latter is
“laying odds.”

In a casino, generally people don’t like laying odds. Take the
craps table, for instance. All the action is on pass line bets
and hardways, where you can risk a little to make a lot.

The casino is not the only place where people are scornful of
laying odds. The stigma attached to risking a lot to make a
little goes back to the release of Nassim Taleb’s second
book, Fooled by Randomness,in the early
2000s.

It wasn’t as big as The Black Swan, but it was very
influential in trading circles and got people to think twice
about selling
straddles and going to lunch.

Mathematically speaking, options are always a tad overpriced. So
yes, it makes sense to sell them. But if you do it
systematically, you run the risk of being exposed to a true black
swan event—and getting carried out.

In the Face of the Biggest Black Swan

A curious aspect of all the VIX sellers smashing vol is the fact
that they are doing so while staring down the biggest-ever
potential black swan—nuclear war. If we attack North Korea, and
it goes sideways,the VIX
isn’t going to 20. It’s going to 100.

People know that deep down, but they think they will be able to
“get out in time.”

That is the
liquidity fallacy—whenever you put on a trade, you must
accept that the liquidity that was present on the way in might
not be present on the way out. You could be “stuck” short vol at
10 and watch helplessly as it reprices to 100. That’s a
bankruptcy trade.

So, experienced traders know that this will come to a very
ignominious end. But in the meantime, party on?

If you’re a short VIX carry monkey, you are betting that nothing
bad will happen, ever. That is verifiably a stupid trade.

But it has worked for a really long time. And to some extent, it
is a self-fulfilling prophecy. If you go in and smash VIX after
something bad happens, you make it not bad.

This happened recently when North Korea flew a missile over
Japan. The VIX smash ensued, and stocks rallied back to unch.

It’s Not Sustainable

There was a paragraph or two in the Times article
devoted to how complex (i.e., toxic) these products are, and how
they are unsuitable for retail investors. I’d bet that most of
these guys don’t know anything about option theory and haven’t
heard of dynamic hedging. They only know that XIV goes up
forever.

If this really does blow up, there is going to be some
soul-searching at the SEC. If you securitize something really
complicated and then apply leverage to it, of course people are
going to trade it!